Preferred shares look good

It’s a difficult time for income investors. Interest rates are drifting even lower, making traditional safe haven securities like GICs less attractive. The big banks are currently paying less than 3 per cent on five-year terms, a level we haven’t seen since the 1950s.

But there are options, including one that many people have forgotten about: preferred shares. In many cases, they offer higher yields than GIC, plus you get a tax advantage through the application of the dividend tax credit.

Higher after-tax return
This means a higher after-tax return to you. For example, a top-bracket Ontario taxpayer will pay tax at a rate of 46.41 per cent on interest income received this year. If the money comes as dividends instead, the effective rate is only 31.34 per cent.

This isn’t just a rich person’s tax break. In fact, the credit works most effectively for lower-income taxpayers. If you have taxable income of between $13,801 and $32,183 in Ontario in this year, your effective rate on dividend income will be only 4.48 per cent. The rate will vary depending on where you live but the principle is the same across Canada.p>

This is a complex and little-understood side of income investing, but preferreds can be rewarding if selected carefully.

Preferred shares (or preference shares as they are known technically) are something of a cross between a stock and a bond. As with bond interest, the dividend is usually (but not always) fixed. However, payments are normally made quarterly, whereas bond interest is paid semi-annually, which gives preferreds an advantage if steady cash flow is important. Preferreds rank ahead of common stocks in the financial pecking order, which means that a company must pay all its preferred dividends first, including any which are overdue, before owners of common stock get a cent. In the event a firm is wound up, preferred shareholders rank ahead of common stock owners but behind bond holders in terms of asset distribution. Normally, preferred shareholders have no voting rights in a company, whereas common stockholders do.

Although the price of preferreds will normally not vary as greatly as that of the common stock of the same company, fixed-rate preferred shares have the potential for a capital gain if interest rates decline, and will tend to fall in value when rates rise, in the same manner as bonds.

Rated as to safety
Like bonds, preferreds are rated as to safety by the national bond rating agencies, with Pfd-1 the highest rating (safest) and Pfd-5 the lowest (most risky). Lower-rated preferreds will usually offer a higher yield, perhaps much higher than normal, but you have to be very careful if you decide to invest in them. The low rating is a red flag; it means the company is likely in financial difficulty. If you pick up the business section of the paper and come across a preferred share with an extraordinarily high yield, you can be sure there’s a good reason for it. No one gives away something for nothing.

You can find ratings for preferred shares by going to the website of Dominion Bond Rating Service at

They are also available in the website of Standard & Poor’s Canada.


Next page: Types of preferred shares and the distinctions between them

There are several types of preferreds and you need to understand the distinctions between them before you plunge in.

Fixed rate preferreds. The dividend payment is fixed and does not vary over the life of the issue. As a result, these preferreds are more interest-sensitive and their market price will be more affected by actions taken by the Bank of Canada.

Floating rate preferreds.  These pay a dividend which fluctuates according to market conditions, based on some formula.  For example, the dividend may be calculated as a percentage of the bank prime lending rate.

Non-cumulative preferreds. With regular preferreds, if dividends are missed they have to be made up later before common stock holders can receive any payment. This is not the case with non-cumulative preferreds, which are often issued by the big banks, so they carry a higher degree of risk. However, non-cumulatives usually offer a better yield than regular preferreds, so you are compensated for the additional risk.

U.S.-pay preferreds. Some Canadian preferred share issues are denominated in U.S. dollars, and pay dividends in that currency. The banks are especially active in issuing this type of stock. U.S.-pay preferreds are eligible for the dividend tax credit and offer an opportunity for currency gains at times when the Canadian dollar is falling.

Convertible preferreds. These allow investors to convert into shares of the company’s common stock according to a specific formula. This feature can produce significant capital gains if the value of the common stock rises well beyond the conversion price.

Preferred shares are best suited to non-registered portfolios because the tax break is lost inside a registered plan.